Futures contract

Hedging with Derivatives; Part 3 of 3: Commodity or Product Input Risk

Companies that depend heavily on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs.  For example, energy intensive manufacturers and transportation companies can be sensitive to the price of gas.  Food product companies can be sensitive to fluctuations in the price of certain agricultural commodities.  Futures contracts on commodities can mitigate a portion of this type of risk.

Futures contracts are sometimes confused with forward contracts.  While similar, they are not at all the same.  A forward contract is an agreement between two parties (such as a wheat farmer and a cereal manufacturer) in which the seller (the farmer) agrees to deliver to the buyer (cereal manufacturer) a specified quantity and quality of wheat at a specified future date at an agreed-upon price.  It is a privately negotiated contract that is not conducted in an organized         marketplace or exchange.

Futures contracts, while similar to forward contracts, have certain features that make them more useful for risk management.  Futures contracts have standardized terms established by the exchange. These include the volume of the commodity, delivery months, delivery location and accepted qualities and grades. The contract specifications differ depending on the commodity in question, but this is the general idea:

A flour miller is concerned about the risk of wheat price increases for wheat to be purchased in November. Wheat futures for December delivery are currently trading at $4.20/Bu, and the typical basis at the miller’s location is $0.15 over futures. The miller hedges this risk by taking a long position (buying) the December wheat future at $4.20. In November, the futures price has increased to $4.40, and wheat is selling locally for $4.55. The miller lifts the hedge by selling back the futures position at $4.40, resulting in a profit of $0.20/Bu. This profit is then applied to the cash purchase cost of $4.55/Bu, resulting in a net cost of $4.35, which is the price expected when the hedge was placed.

For companies sensitive to raw material prices, raw material price variances should be isolated and included in your KPI reporting.  Implementing an effective commodity hedge strategy can minimize these price variances, and the effectiveness of your hedge strategy should be measured and included in the reporting

This concludes the 3 part series explaining how middle market companies can hedge their risks with derivatives.  Happy hedging!

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Hedging with derivatives Part 1 of 3; Foreign Exchange Risk

When a middle market company engages in exporting its products or importing raw materials, it may want to consider hedging the risks related to fluctuations in the currency.  For example, let’s assume your company takes a sales order from a French customer that will be filled in 6 months and you agree on a price in Euro’s.  You know exactly how many Dollars those Euro’s will convert into at today’s exchange rate.  The problem is you don’t know what the exchange rate will be 6 months from now when you get paid.  If the Dollar appreciates versus the Euro, you will end up with fewer dollars than you anticipated when you booked the sale.  To mitigate this risk, you can purchase foreign-exchange futures contracts.  I will not get into the details of how those work, but I will offer these additional tips:

  • If you agree to terms with a customer or vendor involving foreign currency, define the currency and stick with it.  Do not allow the customer/vendor to have their choice between a price in Dollars or the foreign currency.  Doing so would allow them to complete the transaction in whichever currency is favorable to them at the time of payment, which means your company is shouldering all the risk and will likely lose either way.  Make sure your salespeople, AR and AP staff’s understand this and monitor it.
  • As an alternative to hedging, you can structure the sale or purchase contract in a way that shares the risk between the customer and the vendor by locking the current exchange rate on a portion of the total contract.
  • Some companies have a natural hedge, meaning they purchase raw materials in a foreign currency and then sell finished goods in the same currency.  The idea is fluctuations in the currency that drive raw material prices up will also result in higher sales and vice-versa so there is less need for a hedging strategy.  However, due to timing differences, you might think you have a natural hedge but what you really have is twice the exposure and you could actually lose on both ends!
  • Isolate your gains/losses on foreign currency exchange from your other revenue and material costs.  Make it one of the KPI’s you include in your reporting package.
  • Remember, you are not a speculator.  You are a risk mitigator.  If your “hedging” strategy actually makes a lot of money for the company, you are not doing it right.

Next up:  Hedging with Derivatives Part 2 of 3; Interest Rate Risk

Hedging risk with derivatives

Warren Buffet called derivatives “financial weapons of mass destruction”.  Warren is right, as always, but he also understands their purpose.  Derivatives can be extremely risky investments, but when used properly, they are tools to reduce risk.  It is very important when implementing a hedging strategy to build in sufficient oversight & accountability and follow the policy closely.  This not only protects the interests of the company, for the CFO it is about CYA – covering your ass-ets.  When done right, a hedge strategy is like insurance.  It costs the company money and you hope you never need to use it.  It’s about cutting your losses, not making money. The idea is the cost of the hedge is far less than the potential loss had you not hedged.  CEO’s and owners will sometimes forget this point and question why you spent money on derivatives that expired with no value.  If the strategy was clearly presented to them, they participated in the decision and signed off on it, it will help them remember the blurry uncertainty you were hedging against at the time the strategy was implemented, which can be difficult to see when hindsight is 20-20.

To help you evaluate a company’s use of derivatives for hedging risk, in this 3 part series, we’ll look at the three most common ways to use derivatives for hedging.